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May 13, 2013

Quick QE Exit Unlikely, but Do Get a Bond Haircut: PIMCO, Loomis Sayles

Judging from the 10-year Treasury’s yield spike to a two-month high of 1.93% on Monday, fixed-income investors are running for the exits as they prepare for the Federal Reserve to cut back on its quantitative easing program.

But is it really time to start worrying that the Fed has changed its mind about stimulating the U.S. economy and will soon start to end QE and raise rates?

Yes, said The Wall Street Journalon Saturday in an article reporting that the Fed has mapped out a strategy for exiting its $85 billion per month bond-buying program.

“Officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves,” the Journal reported.

But then, the report went on to admit that “the timing on when to start is still being debated,” and the Fed may actually boost its bond buying before it starts dialing down purchases of Treasuries and mortgage-backed securities. In other words, market fears are based more on uncertainty than any actual Fed reduction of its QE program.

So what about the big bond shops like PIMCO and Loomis Sayles? Are they ready to flee fixed income?

Well, no, not just yet. Indeed, the views of PIMCO and Loomis Sayles fixed-income experts suggest that any investor’s exit from the bond market can certainly be an orderly one—if it happens at all. That said, the generous returns of recent years are highly unlikely and duration risk is a key theme.

‘PIMCO’s Advice Is to Continue to Participate in an Obviously Central-Bank-Generated Bubble’

“A bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing,” writes PIMCO founder and managing director Bill Gross (left) in his investment outlook for May, “There Will Be Haircuts.” “PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond.”

“The Treasury’s average cost of money is steadily grinding lower than 2%. If current policies continue to be enforced in future years it will eventually be less than 1% because of the inclusion of T-bill and short maturity financing,” Gross says.

“The government’s gain, however, is the saver’s loss. Investors are being haircutted by at least 200 basis points judged by historical standards, which in the past offered no QE and priced fed funds close to the level of inflation. Large holders of U.S. government bonds, including China and Japan, will be repaid, but in the interim they will be implicitly defaulted on or haircutted via negative real interest rates.”

Gross’ advice to investors is to gradually reduce duration, risk positions and carry as the year proceeds.

Loomis: ‘We Expect the 10-Year Treasury Yield to Remain Below 3%’

Meanwhile, Loomis Sayles Macro Strategies Vice President Rick Harrell uses the metaphor of global climate change in presenting three potential scenarios—“Glacial Period,” “Global Warming” and “Overheating”—to illustrate how the 10-year Treasury yield might evolve over the next five years and beyond.

Harrell predicts in “Climate Change and the Long-Term View on Yields,” released Monday, that “deflationary ice conditions” will keep interest rates depressed until 2016. Fiscal policy will be tight, he says, acting as a drag on growth and tempering reflationary fires, and slow profit growth will lumber along with subpar global demand, particularly from Europe.

“U.S. economic growth should continue to average about 2% for another one to two years, and we think unemployment will decline slowly,” Harrell writes. “We expect the 10-year Treasury yield to remain below 3%.”

As for the Fed, it will continue its loose monetary policy even as conditions improve, he believes.

“We think the Fed will be on hold until 2016. Moreover, open-ended quantitative easing by major central banks, including the Bank of England and Bank of Japan, should weigh on longer-term rates globally,” Harrell writes, adding that overheating in the bond market is unlikely to happen until 2018 at the earliest.

“Following a 30-year secular downtrend in Treasury yields and recent months at historic lows, it is no surprise that many investors are concerned about rising interest rates,” he says. “After a three-decade bull market in government bonds, we are unlikely to see the same generous returns from this asset class in the future; however, this by no means signals the beginning of a secular bear market.”

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